Inspector Clouseau is looking for clues
By Scott Sumner
Over the past 4 years, the Fed has adjusted its policy instrument a total of nine times. In each of those nine cases, the Fed funds target was increased by 1/4%. In each of those nine cases the reason for the increase was identical. All nine increases were done with the goal of reducing inflation—holding inflation down to 2%. That’s it. Period. End of story.
And now there is a great mystery that needs to be solved. Why is inflation running slightly below the Fed’s 2% target? (Core PCE inflation was 1.94% in December 2018.) Here’s Bloomberg:
It’s like a cold case that still baffles investigators. After years of rock-bottom interest rates and with unemployment at 3.8 percent, where is the inflation? It’s a whodunit that hangs heavily over the Federal Reserve.
There are three culprits:
There’s a blizzard of theories aiming to solve the riddle, each with its own set of monetary policy implications. Most economists believe the answer lies in some combination of these ideas, rather than a single culprit.
One bundle of theories holds that the labor market simply isn’t as tight as most economists believe. . . .
2. Secular Disinflation
Economists see a variety of longer-run structural changes that may put downward pressure on inflation. For example, in an aging population older people save more and spend less; baby boomer retirements drive down average compensation. The collapse of organized labor, growing concentration among employers and exposure to international trade represent others. . . .
3. Anchored Expectations
Our last category seems to be the Fed’s favorite person-of-interest. Fed Chairman Jerome Powell told Congress on Feb. 26 that “inflation expectations are now the most important driver of actual inflation.” . . .
I’m going to propose another possible culprit:
4. Excessively tight money
The Fed adopted an excessively tight monetary policy in 2015 and 2016 when it began raising its target interest rate, and this caused the recent undershoot of inflation. (Policy was closer to target in 2018, when the inflation undershoot was small.)
One of the oddities of macroeconomic discourse is that almost no matter what goes wrong, the central bank is not blamed. And that’s even true if the central bank has taken nine consecutive “concrete steps” that would be expected to produce exactly the sort of policy failure that actually materialized. It’s as if I pumped nine consecutive bullets into someone’s chest, and the doctor was puzzled as to why the victim was suffering from chest pains. (In fairness, the inflation miss is rather small and not a major problem for the economy at the moment. So the gunshot analogy is misleading in that respect.)
This also caught my eye:
“It’s almost surely true that inflation is less tightly linked to what’s going on in the real economy than it used to be, and that matters a lot,” said Jeffrey Fuhrer, director of research at the Boston Fed.
Yes, but it’s still pretty closely linked to what’s going on in the nominal economy.
I suppose one could argue that Fed policy has no influence on inflation. But if Fed policy has no effect, then why agonize over policy failures? Of course that would also raise the question of why core PCE inflation is currently 1.94%, and not 23.56%, or 15.45% or negative 11.57%, or some other number. Did 1.94% happen by luck? It seems suspiciously close to 2%.
So let’s say the Fed is capable of controlling inflation. I come back to the original question: Why is Fed policy not considered one of the possible culprits for inflation slightly below target? Especially given that the Fed has tightened policy nine times, with the express goal of holding down inflation.